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Recent Decay in Performance of Many Quantitatively Managed Funds Can be Attributed to Rising Correlations, Style Rotation, “Herding” Phenomena and the Activity of Hedge Funds

The search to find new, unique predictive factors is on, says a study published by the Research Foundation of CFA Institute in the Challenges of Quantitative Equity Management.

London, UK, May 12, 2008 − Participants in a study commissioned by the Research Foundation of CFA Institute have attributed recent decay in performance at many quantitatively managed equity funds to rising correlation levels, style rotation and the fact that there are now more active quantitative managers using the same data and similar models. The problems that many quantitative funds experienced in the summer of 2007 were attributed to the activity of hedge funds’ unwinding positions.

The resulting research and monograph is based on conversations with asset managers, investment consultants, fund-rating agencies, and consultants to the industry, as well as survey responses from 31 asset managers across Europe and the USA with a total of $2,194 trillion in equities under management. The full report is available for free here.

 

Harder to find profit opportunities?

While alpha generation was identified by participants as the most important selling point for a quantitative fund, nearly three quarters of the study’s participants believe that it will become increasingly difficult for quantitative equity managers to find profit opportunities. The reason is that most models rely on similar predictive factors extracted from commercial data sets and academic models, and therefore reach similar conclusions on investment opportunities. Larry Siegel, Director of the Research Foundation of the CFA Institute, commented on the irony that “a discipline that was designed to avoid the herd behaviour of fundamental analysts wound up, in effect, creating its own brand of herd behaviour.”

 

 

 

Strategies to Improve Performance

For quantitative equity managers, the challenge is to add more information and for that information to be unique. A recent development which even large quantitatively managed firms are eyeing with attention is the hybridization of a fundamental approach with a quantitative approach. The belief is that outperformance can be obtained by combining in-depth knowledge of a sector or a listed firm with a more disciplined statistical approach.

 

 

 

However, most quantitative managers and investment consultants that participated in the CFA Institute study are more comfortable with a pure quantitative approach that does not introduce judgement except in rare cases, such as before a big trade. In an effort to avoid being caught holding the same portfolio as every other quant (as apparently happened in the summer of 2007), participants said they will put the accent on identifying new and unique factors. Sergio Focardi, a co-author of the study said, “To identify new and unique factors, quantitative managers will be looking at new sources of information such as detailed balance sheet items, and implementing new modelling techniques such as non-linear models. It seems clear that financial modelling will have to go well beyond today’s widely used linear models, adopting non-linear methods to identify changing market states and commonalities in financial time series and financial news."

 

 

 

Professor Frank Fabozzi, a co-author of the study, said, "It is well known that returns are not normal; multiple standard deviation events can be expected and there are contagion phenomena that might lead to big market swings. Portfolio managers will have to consider these facts in their trading strategies and risk management methodologies."

 

Concentration in the quant arena expected to continue

Participants in the study expect that the quant arena will continue to be dominated by a few big players and a large number of small boutiques. Co-author Caroline Jonas said, “Survey respondents believe that prevailing in-house culture and the ability to recruit the right skills will continue to be the major blocking factor for firms wanting to move from a traditional management approach to a quantitative approach.”

 

 

 

 

Title: Challenges in Quantitative Equity Management
Authors: Frank Fabozzi (in the practice of finance and Becton Fellow in the School of Management at Yale University), Sergio Focardi (partner, The Intertek Group, Paris), Caroline Jonas (partner, The Intertek Group, Paris)
Publisher: The Research Foundation of the CFA Institute
Pages: 120
Available: Here

NOTES TO EDITORS

METHODOLOGY
The Research Foundation of CFA Institute commissioned the authors to undertake research to reveal the trends in quantitative active equity investing. The resulting research and monograph is based on conversations with asset managers, investment consultants, fund-rating agencies, and consultants to the industry as well as survey responses from 31 asset managers. In total 12 asset managers and 8 consultants and fund-rating agencies were interviewed. The survey results reflect the opinions and experience of 31 managers with a total of $2,194 trillion in equities under management. Of the participating firms that are managed quantitatively, 42 percent of the participants reported that more than 90 percent of equities under management at their firms are managed quantitatively and at 22 percent of the participants, less than 5 percent of equities under management are managed quantitatively. The remaining 36 percent reported that more than 5 percent but less than 90 percent of equities under management at their firms are managed quantitatively. The home markets of participating firms are the United States (15) and Europe (16, of which 5 are in the British Isles and 11 are continental). About half (16 of 31) of the participating firms are among the largest asset managers in their countries. Survey participants included chief investment officers of equities and heads of quantitative management and/or quantitative research.

About the Authors

Frank J. Fabozzi is professor in the practice of finance and Becton Fellow in the School of Management at Yale University and editor of the Journal of Portfolio Management. He is a fellow of the International Center for Finance at Yale University, is on the advisory council for the Department of Operations Research and Financial Engineering at Princeton University, and is an affiliated professor at the Institute of Statistics, Econometrics and Mathematical Finance at the University of Karlsruhe in Germany. Professor Fabozzi has authored and edited numerous books about finance. In 2002, he was inducted into the Fixed Income Analysts Society’s Hall of Fame, and he is the recipient of the 2007 C. Stewart Sheppard Award from CFA Institute.

Sergio M. Focardi is a founding partner of The Intertek Group (Paris), where he consults and trains on financial modeling. He is a member of the Editorial Board of the Journal of Portfolio Management and has (co-) authored numerous articles and books, including the CFA Institute’s 2006 monograph Trends in Quantitative Finance and the award-winning books Financial Modeling of the Equity Market: CAPM to Cointegration and The Mathematics of Financial Modeling and Investment Management. Most recently, he co-authored Financial Econometrics – From Basics to Advanced Modeling Techniques and Robust Portfolio Optimization and Management.

Caroline Jonas is a founding partner of The Intertek Group (Paris), where she is responsible for research projects. She has co-authored reports and articles on finance and technology and is a co-author of the books Modeling the Markets: New Theories and Techniques and Risk Management: Framework, Methods and Practice.

About the Research Foundation of CFA Institute
The Research Foundation of CFA Institute is a not-for-profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide.CFA Institute is the global association for investment professionals. It administers the Chartered Financial Analyst^® (CFA^®) and Certificate in Investment Performance Measurement (CIPM) curriculum and exam programs worldwide; publishes research; conducts professional development programs; and sets voluntary, ethics-based professional and performance-reporting standards for the investment industry. CFA Institute has more than 95,000 members, who include the world’s 82,000 CFA charterholders, in 133 countries and territories, as well as 135 affiliated professional societies in 56 countries and territories. More information may be found at www.cfainstitute.org. (Bloomberg users can find CFA Institute at 497458Z).